Founder Passion Versus Investor Fiduciary

Study the Wall Before You Focus on the Road

“When they teach you how to drive a racecar, they tell you to focus on the road when you go around a turn. They tell you that because if you focus on the wall, then you will drive straight into the wall.”    – Ben Horowitz

Ben Horowitz has a great point. There are a myriad of pitfalls that can kill a startup, and worrying about all of them while trying to execute is a folly.

But I have found that not being aware of them at the outset is also a mistake.

I have spent a lot of my career looking into startups that are falling short of where they aimed originally. They are headed for the wall, if they are not already pinned up against it.

For the most part, these companies were not doomed from the outset by a bad idea. Nor did they make a single big mistake. They usually had one bad habit that ground away at them over time, until the only thing left to do was to make a hard turn to avoid crashing.

The most common bad habits:

  • Staying in the basement too long (over-speculating, over-designing, over-building)
  • Concession strategy, trying to be many things at once
  • Being slow to pivot when the evidence is screaming the right answer
  • Scaling prematurely

And you can usually spot the bad habits without having any company history, just by meeting the founders. Founders who love the tech are prone to staying in the basement too long. Founders who are gentle are prone to concession strategy. Founders who talk better than they listen are prone to being slow to pivot and scaling prematurely.

We all have tendencies that pull us in various directions. It’s important to understand those tendencies, and how they can pull you towards the wall if you if you don’t design ways to guard against them.

Weak tendencies, just being aware of them could be sufficient.

Stronger tendencies, you might need to find a co-founder who can counteract.

And the strongest tendencies might dictate which kinds of startups you are capable of leading. For example, I don’t like long odds over long timeframes. I will not build the next Facebook, because in 2006,  I would have snapped-up Yahoo’s $1B offer in a second. Had my co-founders disagreed with me I would have remained firm. Had my investors disagreed with me I would have remained firm. And in hindsight, I would have been dead wrong and responsible for an immense disservice to all stakeholders. So knowing that tendency steers me away from taking on go-long / go-huge plays.

In short, know thyself, and study failure before you start. Understanding all the ways in which you could hit the wall will help you set up your venture in a way that lets you focus on the road.

 

The VC-backed Bullseye, and What Happens When You Miss

Building a successful VC-backed company requires getting everything just right. Getting it right means hitting a bullseye where three factors intersect: Founder Competency, Market Reality, and Investor Approach.

When you hit that intersection, you have a big exit and sail away to your private island. When you miss, you either hire or negotiate, depending on how you miss.

Let’s start by defining the three factors.

Founder Competency

This can be either markets you understand, or innate skills. They will drive your ability to execute well in a one type of venture, and struggle in another. Highly technical founders can have a rocky road building sales-driven orgs, and vise versa. Founders that start in the SMB market might struggle with a pivot into, say, government contracts, even if they spot an open niche. Adapting is hard.

Investor Approach

Investors try to stick to a general approach across their portfolio. At the broadest level, most investors look for scalable tech that can create a big category and have a huge financial outcome. Ventures that live in the cracks simply don’t fit in most portfolios.

A level underneath, most investors have some other thesis, or collection of theses, that guide their investments. For example, the aging US population needs accessible tech. Or industries with information asymmetry are ripe for disruption.

Investors usually talk about their approach when raising funds. Deviation merits some explanation, so there’s friction to changing the approach to accommodate a single portfolio company.

Again, adapting is hard.

Market Reality

While Founder Competency and Investor Approach are visible from the outset, Market Reality isn’t totally clear until a venture has been in the market for a while. What we think is going to happen once we’re in market is usually wrong in number of ways. Our customers might be bigger or smaller than we expected. Our core use case might appear from out of the blue by some happy accident. We pivot and adapt, and hope that the pivots don’t take us too far out of our competencies, or our investors’ approaches.

Market Reality Doesn’t Align with Founder Competency: Hire Leadership

When startups find that their Market Reality doesn’t align with Founder Competency, it’s far from a death sentence. If the founders are sufficiently humble, they’ll find leadership that can fill in the gaps. Investors are usually very helpful in tapping their networks for talent.

Sometimes the transition goes well and sometimes it causes fissures. New leadership might change the tenor of the place in a way that demotivates the team. Or they might try to run a playbook that worked for them in the past that doesn’t factor the nuances of the new venture. Overall, misalignment between Market Reality and Founder Competency is sub-optimal, but workable.

Market Reality Doesn’t Align with Investor Approach: Negotiate

VCs rely on reputation for deal flow, so they are generally forgiving towards portfolio companies that are still finding their way. On the other hand, when it comes to re-investing, they have a fiduciary responsibility to their LPs to not “put good money after bad.”

If you find yourself with a decent business, that you are good at running, that doesn’t fit the approach of investors, you’re in a tough spot. You can’t expect your investors to reinvest in a business that doesn’t fit their model, and you can’t expect new investors to come in if your old investors are sending a cautionary signal.

Those lengthy docs you signed as part of your financing are designed (in part) to protect investors in this scenario. What happens next depends on those docs, and your investors’ willingness to make adjustments. The conversations that follow are awkward, humbling, and may not work out in a way that you like. But the next step is always an honest conversation.

One of the keys to making a VC-backed startup work is making sure all parties are aiming for the same bullseye. Also, understanding how you might miss, and the impact to your viability, should be an important factor in deciding whether you want to seek funding at all.

Yes, You Can Make Your Feature a Successful Business

“Sounds like a feature, not a product.” Anyone who has been on the VC trail a few times has probably heard these words. It’s one of the most common reasons for VCs to pass on your business.

It makes sense. Features don’t get to VC scale, and they can easily get knocked-off by large platforms. For example, Google is notorious for obliterating swaths of startups by adding free features to its suite.

The entrepreneur’s response to the feature-not-product dilemma is often to head back to the drawing board and create a bloated vision around the feature. “We’ll add X, then Y, and eventually disrupt market Z!” The problem is that this fills a VC need, but not a market need. In all likelihood, you started with a feature because the market just wants the feature.

Believe it or not, you can create a business out of a feature. It may not be built to last, or get you famous, but it can deliver a better return than a decent exit after several rounds of VC financing (i.e. after dilution & liquidation preference).

Here are some keys to a successful feature business:

Capitalize for a Modest Exit

Don’t take VC for your feature business. Just don’t. Your investors won’t be happy with your modest plan, the market won’t be happy with an artificial attempt to make it bigger, and you won’t be happy when the proceeds from your sub-scale exit go 100% to your investors. If you uncover a scalable business down the road, you can always raise capital then. VC is designed for scale, period.

Embrace Being Invisible

Whereas most businesses cringe at the thought of letting their brand sit in the background, feature businesses should seize opportunities to ride alongside larger brands. There are two reasons for this: capital efficiency and acquisition positioning. Most of the capital burn in software startups goes towards acquiring customers, so if you’re running lean, it can make sense to give up some margin and brand equity to let someone else do your selling. And, this type of partnership can build the business case for eventual acquisition.

Make Hay While the Sun Shines

Remember, your feature business could get undercut at any time by a larger platform. Make conservative long-term plans, harvest profits while you can, and if you get a good offer for the business, take it.

Your Valuation is Not a Multiple of Revenue

Your prospective acquirers will be looking at your ability to accelerate their feature roadmap, bring a new feature to their existing base of customers, or inject a new set of customers into their base. They will not be growing your current standalone business, so it doesn’t make sense for them to value your business based on revenue. As you consider valuation, consider the value that you are bringing the acquirer; it might be considerably higher or lower than typical revenue multiples.

You probably didn’t set out hoping to create a feature business. But if that’s what you have, structure it correctly for the win.

The Destruction of Perfectly Good Tech

Startup failures send perfectly good tech to the scrap heap. That’s nothing new. What is new is that more and better tech is getting abandoned earlier. It’s an inefficiency created by our convergence around a common playbook.

It starts with taking the path down a very narrow funnel

The standard startup playbook goes something like this: build a product, get some market traction, raise capital, scale revenue, sell for a multiple of revenue. The machine that generates VC returns and founder fortunes has been tuned to this sequence of events.

More often than not, the plan derails somewhere along the way. When the breaking point is revenue at scale, perfectly good tech is often scrapped.

Trouble begins with a big leap from a solution to scalable economics

As entrepreneurs, we look for problems without available solutions. “Hailing cabs is the worst, I wish there were a better way.” Then we create a solution, and can usually find some customers to pay for it.

But a good solution and promising early adoption don’t necessarily portend good economics at scale. As we move beyond early adopters, the cost to acquire customers often outstrips what they’re willing to pay for the solution.

A bootstrapped business that faces this scale constraint can stick to its profitable niche, drop its acquisition costs through channel partnerships, or trim overhead to operate at a slimmer margin. Any of these would be rational moves to keep the business healthy.

However, any of these moves is anathema to the VC-backed playbook. The goal is scalable revenue, and your job is to pivot until you find it, even if the odds start to look slim.

Then, investors get fatigued

The beginning of the end is when your seed investors show fatigue. The runway is getting short, your investors are hesitant to re-up. Without their support, your odds of securing new investors are severely hampered. You are facing a period without cash, or a down round that will likely impact you and your co-founders.

Finally, founders get fatigued

Faced with a down round or a period without cash, you and your co-founders might question the mission. You could look for a buyer, but with a telling P&L and balance sheet, buyers will smell blood and negotiate from a position of strength. Your perfectly good tech is valued as scrap as you near the end of your runway.

By limiting our options, we destroy value

The value of tech and the scalability of a business model are two very different things, but once you are on the VC track, the two become conflated. When the scalable business model fails, it drags the tech down with it.

It doesn’t have to be this way. Good tech can have value within a niche, or wearing another company’s brand, or folded into another company entirely. Just because the tech doesn’t scale as a standalone business model doesn’t meant it is worthless.

When an entrepreneur creates a solution to a problem, it might become an acquirable asset, or a small/medium-sized profitable business, or maybe even a scaled enterprise. Any of those outcomes can create wealth. But in our adherence to a common playbook, we’ve voluntarily crossed two options off the list, and left ourselves with scaled enterprise or bust. The unfortunate result, among other things, is the destruction of perfectly good tech.

2019 is the Year of Sustainable Entrepreneurship

I was looking through a list of around 40 companies that had gone through a certain startup accelerator’s program. Of the 40, I knew of two exits (one small, one large) and one viable continuing operation. 90% of the companies were either gone, or on life support.

Using VC math, one might argue the one big exit created enough benefit to justify the entire portfolio. Perhaps it created a few wealthy founders, who in turn might become angel investors and seed new portfolios.

But what happened to the 90% of founders that failed? I’m guessing they retreated to the corporate world, badly burned, and very few will ever take a second shot. And most of the portfolio companies seeded by the few successful founders will probably face the same fate, and on, and on.

How long before the pool dries up? At what point will prospective founders look down the barrel of a 90% chance of failure and say “no thanks”?

I think we’re getting close to that point. We’re already seeing a slump in seed funding, and some welcome backlash against #struggleporn, #hustleporn, and other rhetoric that keeps founders engaged in a losing game. I predict 2019 will be the year we question what fostering entrepreneurship means, and hopefully, move to a sustainable model.

Fostering Entrepreneurship: 2009–2018

For the past decade, we’ve encouraged founders to create “investable business models”, almost out of thin air. Investable business models have the potential to get huge, usually on the back of a big trend that will catch the eyes of VCs. We’ve focused on maximizing the odds of investment, not maximizing the odds of creating a successful entrepreneur. And those two objectives can absolutely be at odds, as I’ve explained in the past.

I’m not going to beat-up too much on the old model, because I think the results speak for themselves. We’ve designed for outliers, and that’s exactly what we’re getting.

Fostering Entrepreneurship: 2019 Forward

First and foremost, a model for sustainable entrepreneurship needs to create successes for entrepreneurs. I mean successes period — not exclusively huge successes. Nothing creates a thirst for more success than a taste of it.

A model for sustainable entrepreneurship abides by 3 rules:

Rule 1: Small is OK; your first venture may not be your biggest venture.

For most of us, and especially first-time founders, the range of good outcomes extends way below Zuckerberg dollars. Seeing something you’ve envisioned become real, making payroll, and putting enough in your bank account to keep your family happy…that’s a terrific platform on which to build skills. Maybe you get bored after a few years and decide to scale it up, sell it off, or wind it down and launch something more ambitious. If you’ve been able to forego early VC funding, the timeline is yours to control and the bar for a good outcome is within reach.

Somehow, we’ve decided that shooting for a modestly successful outcome is a concession. We’ve been telling first-time skiers to skip the bunny slopes and head straight to the top of the mountain. A few miraculously make it to the bottom, but most end up with broken legs. There is no shame in logging some practice runs before going big in any endeavor, including entrepreneurship.

Rule 2: Know your definition of success

Don’t let your accelerator program tell you that success is raising a seed round, then an A, then a B, then a C, then going public. There are many flavors of success, each faces different timelines, probabilities and capital requirements, and only you can decide which ones fit. It could be that your definition makes you “uninvestable.” In that case, the worst thing you can do is to take investment; you’ll find yourself long-term committed to someone else’s target.

Rule 3: Celebrate business victories more than fundraising victories

Everyone acknowledges that raising capital is a means to an end, not an end in itself. And most everyone, including VCs, agrees that fundraising is often incorrectly portrayed as a clear win instead of a mixed blessing.

This consensus is getting lost on its way to the press. Fundraises account for most of the startup news out there, and are always portrayed as clear victories. It’s probably too much to ask for more balanced reporting on fundraises; the ugly particulars are not usually made public, and would only serve to buzzkill a good headline.

More realistically, we can start shining a light on successes outside of fundraising. Since these stories may not be event-driven, it’s incumbent on us, the entrepreneurial community, to bring them to the press.

A lot of hype has been created around startups over the past decade. There is no shortage of interest in becoming an entrepreneur. In order to keep the interest from fizzling, we now need to help deliver real successes, which requires rethinking how we’ve defined success in the past.

A Startup CEO’s Job is to Master the Narrative

I grade myself a solid ‘B’ at sales. I can get the job done, but not nearly with the aplomb of many others I know.

Still, one of the biggest mistakes I ever made as a CEO was hiring an ‘A’ seller too early. In doing so, I extracted myself from talking with prospects, at a point when their feedback was key to forming the company narrative.

‘The Narrative’ doesn’t reside exclusively within the 10-slide macro disruption story you’re pitching investors. It starts at a much more basic, tactical level. It is the very core of why your product exists, who it’s helping, and why they should pay money for it. The only way to forge a good narrative with startup speed is to be directly in touch with customers.

Remember the Telephone Game?

The telephone game — where people in a line verbally pass a message, and by the end of the line the message is completely transformed. If you are expecting your sales and support team to feed you intelligence to form the narrative, you’re playing the telephone game.

Direct interactions with customers are full of subtle clues that get lost in translation. You can feel when a prospect gets excited about a feature, or when a pricing objection is a negotiation versus a statement on your value. When a customer asks for a feature, the dialog around the ask might point you to a potentially game-changing differentiator. These key strategic insights can be subtle.

It’s not that sales and support are going to miss the messages. In fact, if they are good at their jobs, they are probably just as good as you at listening and picking up subtleties. Where the messages get lost is in route to you. Language fails in its ability to relay subtext.

It Might be Painful for Introverts

Maybe you find talking to customers and prospects exhausting. Maybe you grade yourself a ‘C’ or even a ‘D’ at sales.

Give yourself permission to be exhausted, or to suck at selling. At the very early stages, whether or not you close the deal is not nearly as important as your mastery of the narrative. The more you stay in front of customers, the faster you’ll master the narrative. The faster you master the narrative, the sooner you’ll be able to extract yourself from the front lines.

You Can’t Skip this Step

First you master the narrative, then you scale. You might see a spark and be tempted to pour gas on it, or your investors might be pushing you to hit aggressive growth targets before the narrative is solid. Don’t do it. Premature scaling, i.e. using equity capital to numb the pain you should feel from a flimsy value proposition, is the number one error that startups make.

The number two error is hiding in the basement and not selling at all. You learn by selling. Don’t confuse waiting to scale with waiting to sell.

Getting the narrative right is a messy and sometimes painful process. But as CEO, it’s one of your most important jobs. To do it right, you need to stay in front of customers until you’ve mastered the narrative.

4 Startup Tenets that Won’t Survive a Downturn

I spent the go-go days of the late 90’s in a rare Internet startup for the era. Due to groundwork laid before I arrived, we were profitable. We declined most of the VC we were offered, watched our overhead, and grew methodically. We were misfits of the so-called “new economy,” and we sold for 30x capital invested right as the bottom fell out of the Internet industry.

What I learned from this experience is that industry dogma emerges when startups are hot. And that same dogma is discarded just as quickly when things collapse.

During the recent startup boom, we’ve seen a new dogma emerge. When the cycle ends, I’m expecting the following 4 tenets to disappear along with the good times:

1. A million dollars isn’t cool, a billion dollars is cool

Call me old fashioned, but I think a million dollars is cool, especially if you invested far less than a million dollars to earn it. Somehow, we’ve arrived at a point where “real” entrepreneurship is about pursuing long odds of massive outcomes, and anything short of that is dismissed.

Long odds work fine across a VC portfolio, which is probably why they have become the standard. But just because the formula works well across a VC’s portfolio, doesn’t mean it works on an entrepreneur’s single asset.

I mostly cringe at this tenet because I think it does an enormous disservice to first-time entrepreneurs. Launching a longshot, burning through someone else’s capital, then shutting down is a terrible way to cut your entrepreneurial teeth. Successes are just as important to learning as failures. If you get scorched so bad on the first one that you never try again, how is that “real” entrepreneurship?

2. Never give up

Giving up has its place. I have experienced that startup phenomenon where one day the future looks bleak, then the next day it doesn’t. But I have only experienced it when I knew that fundamentally, we had something of value. I have also experienced being in a hole with no way out, where the best move was to look for a soft landing.

As a steward of other people’s capital and time, there is nothing heroic or romantic about squandering either on a lost cause. Sometimes, the right thing to do is to redeploy what’s left into something more productive.

3. Hustle & grind, always

Speed is critical to startups. Given the fact that big incumbents have all the people, money and customers they need to squash new entrants, you could even say that speed is the only advantage at startups. I love the hustle & grind.

At the same time, two of my most positively pivotal moments came when business got so bad that I stopped hustling entirely. I stepped back, stopped selling, thought hard about the business, and made fundamental changes. Had I just kept grinding, I would have undoubtedly ground the business into dust.

You can’t hustle your way out of a bad business model. Sometimes, you have to pull back resources, stop, and think hard before you make your next move.

4. Profitability is idiotic

I recently watched a prominent VC tell an audience, “founders who think about profitability are idiots.” Verbatim. His logic — SaaS companies sell on a multiple of revenue, so you should plow all your available resources, including profit, VC and debt, into that metric.

I understand the math, and it works as long things are going well and continue to go well. But you can’t gracefully step off of that treadmill if you stumble. Most startups (and markets) stumble, so again, this tenet is designed for the exception not the rule. A plan for profitability is far from idiotic; it can be the difference between success and failure.

Wouldn’t it be great if we could boil startup success down to a handful of universal truths? But startups are working with too many variables to abide by dogma. The dogma only emerges when startups are so hot that hype drowns out complexity, which never lasts for long.

6 Metrics that are More Important to Your Startup than Revenue

When asked about “traction,” entrepreneurs assume it’s in reference to revenue. Revenue seems to have eclipsed other metrics as an overall indicator of how well the business is doing.

I think the rise of revenue has something to do with blowback from the late 90s, when we suspended traditional financial indicators for our so-called new paradigm. It did not end well. We learned the hard way that financial indicators are important, so we returned to them with a vengeance. “Engagement, whatever…how much money are you making?”

In our back-to-basics approach, we’ve buried some metrics that are more important than revenue because of what happens to most startups; they either die, or are acquired by a bigger company. Revenue itself isn’t the main driver of those outcomes. Acquisitions are more likely to come from how your product can be applied to a much larger installed base of customers, or how your tech or market presence can accelerate an acquirer’s roadmap.

Your revenue might give an acquirer a sense of your viability as a standalone business, thus setting a lower bound on what they will offer. But it will not set their value on your company.

Here are 6 metrics that matter more than revenue:

#6 Gross margin

Gross margin doesn’t tell a story by itself. There are plenty of great low-margin, high-volume businesses. Gross margin is good for gauging how many options you have at your disposal. A high gross margin usually means you can adjust if things don’t go as planned. For example, you have room to drop price if competition stiffens, or you can make a move to profitability if financing gets tight.

#5 Liquidation preference

Liquidation preference is simply the “first dibs” preferred shareholders have on your proceeds from a sale. It’s the bar you have to get over before you can divvy proceeds to other shareholders like founders, employees, etc. It’s not debt, but it can sure feel like it when you are trying to make all classes of shareholders happy. Liquidation preference puts boundaries on your available strategic options. If liquidation preference is high, you can forget about being satisfied with dominating a small niche, or taking a modest acquisition offer (unless it’s that or fold-up entirely).

#4 Revenue concentration

There are various ways to measure revenue concentration; all of them gauge how much of your revenue is at risk from losing your top customers. High revenue concentration puts a serious pinch on valuation because a single instance of churn can send the company into disarray. A typical treacherous startup path: chase big customers to drive revenue growth, add overhead to cover problems with an immature product and keep those customers, end up in a more precarious spot than had you foregone the revenue altogether.

#3 Months to cash zero

Running out of cash is obviously very, very bad. Not much else to say except, if you are driving revenue at the expense of your cash runway, you should have a good plan for how that turns around.

#2 Churn

Assessing whether your customer churn is high or low can be complex. There are markets with endemic churn, like weddings, infant care, Realtors, SMBs, as well as business models with endemic churn. It’s important to have your own internal benchmark. Like an EKG monitor flat-lining, when churn is high, you stop what you’re doing and address the root issue. The root issue can be hard to uncover. It can be pricing, support, missing features, bad tech, renewal timing, or competition. Whatever the case, as long as the problem goes unaddressed, all the resources you are spending on sales and product are potentially for naught.

#1 Cost of the problem you are solving for would-be acquirers

Ultimately, the value of your company will be measured by the problem you solve for an acquirer. That problem is either (a) product (capabilities, features, something new to sell to their customers), or (b) market (an entry point into a certain type of customer). Value is not simply a matter of what it costs BigCo to build your product, although that is part of the equation. It’s mostly a matter of how long it would take them to build it, and the opportunity they are passing up in the process. Projects can move slowly in a big company, and the ability to unlock value now can justify a high price.

Focusing on revenue for an outcome that won’t have much to do with revenue is like training for Sport A, then playing Sport B. A lot of the skills you learned will transfer, but you would have been better off practicing directly relevant skills all along